Inventory accounting: GAAP allows LIFO, IFRS doesn't

One of the starkest and most material differences between GAAP and IFRS is inventory costing. GAAP permits companies to use LIFO (Last In, First Out), which is prohibited under IFRS. This is not a subtle technical difference—it is a fundamental choice that changes reported cost of goods sold, gross margin, net income, and tax liability. For investors comparing a US company to an international competitor, or analyzing a US company's true earnings quality, understanding inventory accounting is essential.

This article explains how LIFO, FIFO, and weighted average work, why they produce different results, why IFRS banned LIFO, and how to adjust for the difference when comparing companies across GAAP and IFRS regimes.

Quick definition: LIFO (Last In, First Out) values inventory by assuming the most recently purchased units are sold first. FIFO (First In, First Out) assumes the oldest units are sold first. Weighted average is a midpoint. GAAP allows all three methods; IFRS only allows FIFO and weighted average. In inflationary environments, LIFO produces lower gross margin and net income but higher cash tax benefits.

Key takeaways

• GAAP permits four inventory costing methods: FIFO, LIFO, weighted average, and specific identification. IFRS prohibits LIFO.
• In periods of inflation (rising input costs), LIFO produces lower reported earnings (higher COGS) and lower taxable income compared to FIFO.
• In periods of deflation (falling input costs), LIFO produces higher reported earnings and higher taxable income compared to FIFO.
• Many US companies use LIFO for tax purposes (the IRS allows it), which means using LIFO for reporting is mandatory (tax and book accounting must align).
• Comparing a LIFO company's gross margin to an IFRS company's (which uses FIFO or weighted average) is not apples-to-apples without adjustment.
• IFRS prohibits LIFO because it argues that LIFO does not reflect the actual physical flow of inventory and produces balance sheets with stale inventory values.
• Large retailers and commodity companies (oil & gas, metals) are most affected by the LIFO/FIFO difference.

1. How LIFO, FIFO, and weighted average work

Let us start with a concrete example. Imagine a retailer that sells widgets. In January, it buys 100 units at $10/unit. In March, it buys another 100 units at $12/unit (prices have risen). In May, it sells 100 units. Which units were sold—the old cheap ones or the new expensive ones?

In the real world, it depends on how the company physically stores and ships inventory. But for accounting purposes, the company chooses a cost-flow method:

FIFO (First In, First Out):

• Assume the January units (bought at $10) are sold first.
• COGS = 100 units × $10/unit = $1,000.
• Ending inventory = 100 units at $12/unit = $1,200 (balance sheet).
• In inflation, FIFO produces higher COGS but newer inventory on the balance sheet.

LIFO (Last In, First Out):

• Assume the March units (bought at $12) are sold first.
• COGS = 100 units × $12/unit = $1,200.
• Ending inventory = 100 units at $10/unit = $1,000 (balance sheet).
• In inflation, LIFO produces lower COGS but older inventory on the balance sheet.

Weighted Average:

• Calculate average cost per unit = (100 × $10 + 100 × $12) / 200 = $11/unit.
• COGS = 100 units × $11/unit = $1,100.
• Ending inventory = 100 units × $11/unit = $1,100.

Summary table:

Method	COGS	Ending Inventory	Gross Margin
FIFO	$1,000	$1,200	Higher
Weighted Avg	$1,100	$1,100	Mid
LIFO	$1,200	$1,000	Lower

If the sales price is $1,500 per 100 units, gross profit is $500 (FIFO), $400 (WA), or $300 (LIFO). Same business, same sales, different reported profit depending on method.

2. The tax advantage of LIFO

The reason many US companies use LIFO is tax, not financial reporting. Under the US Tax Code (Section 472), companies can use LIFO for tax purposes. When prices are rising, LIFO produces lower taxable income, which reduces taxes owed.

Example: A company with the inventory scenario above would owe taxes on gross profit of:

• FIFO: $500 × 35% (hypothetical tax rate) = $175 tax.
• LIFO: $300 × 35% = $105 tax.

The company saves $70 in taxes by using LIFO.

Over decades of inflation, companies using LIFO accumulate substantial tax savings. However, there is a catch: if a company uses LIFO for tax purposes, it must also use LIFO for financial reporting (this is called the LIFO conformity rule). The company cannot use LIFO on its tax return and FIFO in its 10-K.

This rule is unique to the US. Most countries do not allow LIFO for tax purposes (they consider it economically misleading). So LIFO is predominantly a US phenomenon.

3. Why IFRS prohibits LIFO

IFRS, which applies globally, prohibits LIFO. The IASB's reasoning is straightforward:

1. Economic substance: In most real-world businesses, the oldest inventory is sold first (FIFO), not the newest. Grocery stores, for example, rotate stock. LIFO does not reflect this physical flow.

2. Balance sheet quality: LIFO produces stale inventory values on the balance sheet. A company using LIFO since 1970 might have inventory on the books at 1970 prices, which is economically meaningless. A balance sheet is supposed to reflect current financial position; stale inventory values undermine this.

3. Comparability: LIFO is unique to the US, so companies in the same industry across countries use different methods, complicating comparison.

4. Earnings manipulation: Bright-line rules can be gamed. If a company does not sell inventory in a period, it adds to the LIFO layer, and that layer stays on the books until sold. Companies can manipulate earnings by strategically selling (or not selling) old LIFO layers.

The IASB's position is that FIFO or weighted average better represent economic reality and produce more comparable, meaningful financial statements.

4. The LIFO reserve: translating LIFO to FIFO

Because GAAP allows LIFO and IFRS does not, a US company using LIFO must disclose a "LIFO reserve" in its footnotes. This reserve is the cumulative difference between LIFO inventory and what inventory would be under FIFO.

Example: A company's balance sheet shows inventory of $50 million (LIFO). The footnote discloses a LIFO reserve of $15 million. This means if the company had used FIFO, inventory would be $65 million ($50 million + $15 million).

The LIFO reserve grows each year inflation exceeds sales (when new, expensive inventory is added to the LIFO layer). The LIFO reserve shrinks if prices fall or if inventory is sold (the old, cheap LIFO layers are liquidated).

For an investor, the LIFO reserve is useful: it allows you to "adjust" the LIFO company to FIFO for comparison purposes.

Adjustment example:

• Company A (LIFO): Inventory $50M, COGS $200M.
• Company B (FIFO): Inventory $65M, COGS $190M.
• Unadjusted, Company B looks less profitable ($190M COGS vs $200M).
• But if Company A's LIFO reserve is $15M, and Company A's ending inventory is $50M LIFO, we can estimate:
  • If Company A had used FIFO, COGS would be roughly $200M - $1M (approximate annual LIFO reserve increase) = $199M.
  • Now A and B are more comparable.

The adjustment is approximate because the LIFO reserve does not change linearly with COGS. But it gives investors a ballpark estimate of what LIFO earnings would be under FIFO.

5. Which companies use LIFO?

LIFO is not universal in the US. Certain industries predominate:

Heavy LIFO users:

• Retailers: Walmart, Best Buy, and other large retailers use LIFO. In high-inflation periods, LIFO depresses earnings and taxes.
• Petroleum and gas: Oil refiners and gas producers use LIFO because commodity prices fluctuate wildly.
• Metals and mining: Aluminum, copper, and other metal producers use LIFO for similar reasons.
• Chemicals: Commodity chemical producers use LIFO.
• Pharmaceuticals and manufacturers: Some use LIFO, though increasingly, companies shifted to FIFO or weighted average.

Light LIFO users:

• Technology: Software and hardware companies rarely use LIFO (they typically use standard cost or specific identification).
• Healthcare: Hospitals and medical device makers use average cost or specific identification.
• Consumer staples: Some food and beverage companies use FIFO.
• Financials: Banks do not have inventory (so LIFO is not applicable).

The prevalence of LIFO has declined over the past 20 years. Many companies switched from LIFO to FIFO or weighted average for simplicity (LIFO requires detailed layer tracking) and to align with IFRS (if they have international operations).

6. LIFO liquidation: the hidden earnings boost

One important phenomenon with LIFO is "LIFO liquidation." If a company sells more inventory than it purchases in a period (drawing down inventory), old LIFO layers are sold. Old layers have low costs (from prior years when prices were lower). Selling them produces higher gross margin and unexpected earnings.

Example: A company has three LIFO layers:

• Layer 1 (2010): 50 units at $10/unit = $500.
• Layer 2 (2015): 50 units at $15/unit = $750.
• Layer 3 (2023): 50 units at $20/unit = $1,000.
• Total inventory: 150 units at average cost of $15.33/unit.

In 2024, the company sells 120 units (drawing down inventory) but only buys 50 units (due to supply chain issues or demand decline). It must sell Layer 1 (all 50 units) and Layer 2 (70 units). COGS is (50 × $10) + (70 × $15) = $1,550. Gross margin improves because old, cheap costs are matched to current prices.

However, Layer 1 is very old (2010). Reporting a $500 cost for a unit that may have depreciated or obsolesced is economically misleading. But under LIFO, the company must recognize the gain.

For investors, a sudden spike in gross margin or operating income during a period of inventory liquidation is a red flag. The improvement is not from better operations; it is from selling old inventory at outdated costs. The income is "unusual," and investors should adjust for it when assessing recurring earnings.

7. LIFO in practice: Walmart's LIFO inventory

Walmart, the world's largest retailer, has historically used LIFO for significant portions of its inventory. This means Walmart's reported gross margin is depressed relative to FIFO peers. Walmart's balance sheet also shows inventory at much older values than it economically represents.

In Walmart's 10-K, the company discloses the LIFO reserve, which has been substantial. In recent years, Walmart has reduced its LIFO usage (shifting to other methods), partly to align with IFRS for consolidated reporting and partly because LIFO tracking has become more costly.

For an investor comparing Walmart's margin to a competitor like Costco (which uses different inventory methods), the LIFO difference must be adjusted.

8. The LIFO vs FIFO choice and earnings quality

The decision to use LIFO is often driven by tax considerations, not by financial reporting quality. A company uses LIFO because it saves taxes. But from a financial reporting perspective, LIFO has lower earnings quality because:

1. Less faithful representation: LIFO does not reflect the actual flow of inventory.
2. Older balance sheet values: Inventory is stated at old costs.
3. Earnings volatility: LIFO liquidation can cause unexpected earnings spikes.
4. Reduced comparability: Comparing a LIFO company to FIFO peers is difficult.

An investor might actually prefer a company that uses FIFO, despite higher reported earnings, because FIFO earnings are more reliable and more comparable to peers.

However, the tax advantage of LIFO is real and material. A company using LIFO is genuinely saving taxes. So the choice is not simple: LIFO earnings are lower quality, but LIFO saves taxes (which benefit shareholders). Which effect dominates depends on the company's cost structure and inflation environment.

9. Adjusting for LIFO/FIFO differences when comparing companies

If you are comparing a GAAP company (potentially using LIFO) to an IFRS company (using FIFO or weighted average), here is how to adjust:

Step 1: Identify inventory accounting method.

• Read the accounting policy footnote in the 10-K or annual report.
• If the company discloses a "LIFO reserve," the company is using LIFO.

Step 2: Obtain the LIFO reserve (if available).

• For US GAAP companies using LIFO, the footnote discloses the reserve.
• For IFRS companies, there is no LIFO reserve (because LIFO is prohibited).

Step 3: Adjust inventory on the balance sheet.

• LIFO inventory = Current year inventory (LIFO).
• FIFO-equivalent inventory = LIFO inventory + LIFO reserve.

Step 4: Estimate FIFO COGS (approximate).

• Change in LIFO reserve = (This year's reserve - Last year's reserve).
• FIFO COGS ≈ LIFO COGS - Change in LIFO reserve.

This is an approximation because the relationship is not perfectly linear, but it gives you a ballpark estimate.

Example:

• Company A (LIFO): Inventory $50M, COGS $200M, LIFO reserve $15M (current year), $14M (prior year).
• FIFO inventory = $50M + $15M = $65M.
• Change in reserve = $15M - $14M = $1M (the reserve grew by $1M).
• Estimated FIFO COGS = $200M - $1M = $199M.

Now Company A's margin is more comparable to Company B (FIFO).

10. The future of LIFO: will it disappear?

There has been long-standing discussion of banning LIFO in the US, aligning with IFRS. The arguments for banning LIFO:

• International convergence: Eliminating a major GAAP/IFRS difference would simplify accounting.
• Earnings quality: FIFO and weighted average are more faithful to economic substance.
• Simplicity: Companies would no longer need to maintain LIFO layers.

However, there are strong arguments against banning LIFO:

• Tax impact: Banning LIFO would require many companies to reverse accumulated LIFO reserves, creating a one-time tax bill. Estimated to be tens of billions of dollars globally. Congress would have to act, and tax reform is contentious.
• Industry opposition: Retailers, commodity producers, and other LIFO users lobby against any change.
• Gradual obsolescence: LIFO usage is already declining as companies move to other methods or shift to IFRS. The problem may solve itself over time.

The SEC and FASB have discussed banning LIFO for years but have not acted. It is unlikely to happen in the near term, though it remains possible in a broader tax-reform context.

For investors, this means LIFO is likely to remain a difference between GAAP and IFRS for at least the next decade.

Real-world example: oil industry inventory accounting

The oil refining industry heavily uses LIFO because crude oil and refined products are commodities with volatile prices. When oil prices spike (as they did in 2008 and 2022), refiners using LIFO report significantly lower earnings than refiners using FIFO, even though they made the same economic profit.

During the 2008 oil price surge, investors comparing Valero Energy (a LIFO refiner) to its European peers using FIFO would have seen Valero report much lower earnings. Some investors thought Valero was struggling; in reality, the difference was purely accounting. The LIFO reserve disclosure would have revealed the gap.

Similarly, in 2022, when oil and gas prices surged, oil companies using LIFO saw depressed earnings. Companies that had switched to FIFO reported higher earnings from the same commodity price increase.

Common mistakes

Mistake 1: Ignoring the LIFO reserve. If a company discloses a LIFO reserve, always read it. It is material and affects balance sheet and earnings comparability.

Mistake 2: Comparing margins without adjusting for inventory method. A LIFO company's gross margin will look worse in inflation than a FIFO peer's, even if they have the same cost structure. Adjust before comparing.

Mistake 3: Assuming LIFO earnings are low-quality. LIFO earnings are lower quality in terms of balance sheet representation, but they are tax-efficient. A LIFO company is genuinely saving taxes, which benefits shareholders. Do not dismiss LIFO companies outright.

Mistake 4: Not identifying LIFO liquidation. If a company reports a sudden margin spike in a year of inventory reduction, ask whether it is LIFO liquidation. If so, adjust for the one-time benefit.

Mistake 5: Assuming all inventory methods are equivalent. FIFO, weighted average, and specific identification all produce different results in inflation. Read the policy footnote.

FAQ

Q: Can a company switch from LIFO to FIFO?
A: Yes, but it requires disclosure and an SEC approval (effectively). Switching has a material impact on earnings and requires an accounting change disclosure in the 10-K. Additionally, if the company switches for tax purposes, it triggers a one-time tax bill for the LIFO reserve.

Q: Does IFRS ever allow LIFO in special cases?
A: No. IFRS prohibits LIFO entirely, with no exceptions. This is a fundamental difference from GAAP.

Q: How large can a LIFO reserve be?
A: Very large. For a company using LIFO since the 1970s, the reserve could be 20–40% of reported inventory. Walmart's historical LIFO reserves have been in the billions of dollars.

Q: If I invest in a European company, do I need to worry about LIFO?
A: No. European companies follow IFRS, which prohibits LIFO. You only need to worry about LIFO for US GAAP companies.

Q: Can a company use LIFO for some inventory and FIFO for other inventory?
A: Yes, called "pool" LIFO. A company can segment inventory into pools and use LIFO for some pools and FIFO for others.

Q: Does the LIFO reserve affect taxes?
A: The LIFO reserve is a cumulative tax benefit. If a company reverses LIFO (switches to FIFO), it must pay taxes on the accumulated reserve, which can be a massive tax bill.

Related concepts

• Inventory on the balance sheet — Inventory valuation and obsolescence testing.
• GAAP vs IFRS: the big-picture differences — Inventory costing is one key difference.
• Cost of goods sold — COGS calculation and structure.
• Working capital — Inventory is a component of working capital.

Summary

GAAP allows LIFO, FIFO, and weighted average inventory costing; IFRS allows only FIFO and weighted average. LIFO produces lower reported earnings in inflationary periods (higher COGS) but provides a tax advantage, which is why many US companies use it. IFRS prohibits LIFO because it does not reflect the actual flow of inventory and produces stale balance sheet values. Comparing a LIFO company to an IFRS (or FIFO) company requires adjusting for the inventory method difference using the LIFO reserve disclosure. The choice of inventory method is a significant driver of earnings quality and balance sheet accuracy, and investors should always check which method a company uses before comparing it to peers.

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Development costs: capitalised under IFRS, expensed under GAAP

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